Indian corporates recorded rapid profit growth during FY04-08 at a CAGR of 28%. Only if the profits entirely came in from business operations. According to a study by London-based investment bank Noble Group, these profits were mainly due to easy availability of external financing and not operating cash flow growth. Noble is a research driven equity investment bank that specialises in UK and Indian mid and small capitalisation companies.

The profit numbers were fudged through creative accounting, as high growth in profit was not accompanied by corresponding operating cash flows (only CAGR of 15%) leaving a gaping hole between profits and cashflows, the study indicated. The creative accounting practice is not limited to one or two companies, but has been followed by several hundreds of companies. An analysis of 2,637 non-financial companies by the investment bank show that cashless profit growth is driven by non-cash, non-operating sources of profit. A few items such as depreciation, interest payable, interest income and other expenses have been used to fudge profits.

Operating Cash flows to Hold again

Fudging of profit numbers is not new to the corporate world, but have implications in the post-Satyam scenario. However, the good news is that India Inc’s operating cashflows were resilient even in the tough years between FY01-03.

The report compares two periods – FY01-03 (considered to be lean years for India) and FY04-08 (the “India story” years). The operating cash flow CAGR was actually higher in FY01-03 with 23% compared to 12% of FY04-08. This is mainly because working capital requirements were low in FY01-03.

But FY09 profits will appear especially vulnerable, as post-Satyam, Indian auditors are prepared to produce a relatively “unfudged” set of numbers for the year. Such a set of clean accounts would mean that for the first time since FY03, the gap between profits and operating cash flows will narrow dramatically. Hence, whilst profits are now set for a correction, the bet is that operating cashflows will once again hold up very well.

Indian Companies Superior Than The US & The UK

No matter, a raging bull market coupled with the obsession of investors and analysts with P/E multiples forced companies to show strong earnings growth, India is far more superior positioned than the US and the UK from a free cashflow perspective at every point in the recent economic cycle, the study said.

With external sources of financing drying up, the more advanced economies have gone through a much more exaggerated version of what India has been through as there were big surges in investing cash flow (CFI) in the UK and the US financed by external capital issuance reflected in cash flow from financing activities.

Talking even on a conservative basis, if Indian GDP recovers to 6%+ in H2FY10, both on macroeconomic and corporate fundamentals, India appears a lower risk bet than the more advanced economies. But before investors indulge in investing in growth companies in the country, it would make sense to focus on operating cash flow rather than headline PAT/PBT for Indian companies. Fudged company, anyone?